Captive insurance can benefit eligible small and mid-sized businesses by helping provide a more customized and strategic approach toward certain insurance needs and risk exposures.
While captive insurance can be appropriate for some businesses, the path is not as simple as selecting a captive structure and beginning the process of purchasing alternate risk financing. Captive insurance involves financial, legal, and regulatory considerations.
Carefully evaluating a company’s needs and insurance exposures is the best way to determine whether the opportunity makes economic sense. A detailed examination of captive insurance, including risks, costs, feasibility, and practical considerations, follows.
Table of Contents
- Why Businesses Are Rethinking Traditional Insurance
- What Is Captive Insurance?
- How Does Captive Insurance Work?
- Why Small and Mid-Sized Businesses Consider Captives
- Types of Captive Insurance Companies
- What Risks Can a Captive Insurance Company Cover?
- Captive Insurance vs. Traditional Insurance
- Is Captive Insurance Right for Your Business?
- Understanding the Costs of Forming a Captive
- The Importance of a Captive Insurance Feasibility Study
- Potential Tax Considerations
- Common Captive Insurance Mistakes to Avoid
- How to Get Started With Captive Insurance
- Expert Insights
- Statistics
- FAQs
- Conclusion
- Contact Bespoke Insurance Groups
Why Businesses Are Rethinking Traditional Insurance
For small and mid-sized business owners, commercial or traditional insurance is an annoyance. Companies buy policies and pay the premium, with the hope that a serious claim will never have to be submitted. Yet, just as businesses begin to believe they have stabilized their exposure and risk management, the costs increase, despite a strong safety culture.
Traditional commercial insurance coverage is appropriate for many businesses. However, for organizations with significant annual insurance costs, strong safety and risk management initiatives, and the ability to invest in alternative risk financing, exploring options becomes a responsible risk management practice. Captive insurance provides an opportunity to obtain more control over eligible insurance costs.
What Is Captive Insurance?
A captive insurance company is an insurance company that is owned and controlled by the businesses or individuals it insures. Organizations that purchase commercial insurance typically do not have any ownership interest in, or control over, the insurers. By contrast, a captive insurance company provides coverage and assumes risk for the business that owns it.
In other words, captive insurance means that a company obtains more control over its eligible insurance needs. This enhanced control extends to risk retention in general and the reinsurer for catastrophic risks in particular. There are numerous forms of captive insurance companies, including structures that are suitable for small and mid-sized businesses.
A business or group of affiliated businesses may purchase insurance from a captive in the same way it would buy coverage from a commercial insurer. The captive receives the premium, retains a percentage as profit, and purchases reinsurance to cover large or catastrophic losses. While it is appropriate for some companies to utilize a captive insurance company, this type of alternative risk transfer is not appropriate for every organization.
How Does Captive Insurance Work?
The premise of captive insurance is simple: businesses that purchase insurance from a commercial carrier do not have any ownership interest or control over that entity. A business that establishes a captive insurance company, however, can obtain a greater degree of control over its eligible insurance costs.
There are several options for creating a captive insurance structure. The basic process involves identifying appropriate risks to insure, forming or purchasing an appropriate captive structure, purchasing reinsurance, and funding the captive to cover projected losses.
Businesses that consider a captive insurance company typically follow these steps:
- Businesses identify insurance risks
- A captive structure is formed or purchased
- Businesses pay the captive premium for qualifying coverage
- The captive purchases reinsurance for its retained risk
- Eligible risk is transferred to the captive, retained, or reinsured
- Claims are reviewed and approved
The realities of captive insurance are considerably more complicated than this summary suggests. Because a captive is both an investment and an insurance structure, companies must carefully consider the risks and reward. There are a number of critical issues related to capitalization, risk, claims, governance, documentation, and regulation that must be addressed in detail.
Why Small and Mid-Sized Businesses Consider Captive Insurance
Captive insurance companies have typically been utilized by larger organizations. However, some small and mid-sized businesses may also benefit. Commercial insurance is not always a flexible product. Even businesses with outstanding safety and risk management programs may find that premiums increase due to industry trends, despite their efforts to reduce losses.
If a company has significant insurance costs, risk exposures, and the financial and managerial capacity to establish and maintain a captive, then the opportunity should be explored.
The benefits of utilizing a captive insurance company to finance and manage qualifying risk include the following:
- Increased control over insurance costs
- Customized solutions for the business’s unique risk exposures
- Access to the reinsurance markets for large or catastrophic losses
- Enhanced risk management practices
- Additional transparency regarding claims and expenses
- Potential long-term benefits if qualifying risk exposures decline
These advantages are dependent on a number of factors, including the type of business, size, risk exposures, and management capabilities. Captive insurance is not necessarily right for every business with significant insurance costs.
Types of Captive Insurance Companies
Captive insurance companies take many different forms. The options available to small and mid-sized businesses are typically limited to single-parent and group captives, although protected and segregated cell structures may also be available.
Single-Parent Captive
A single-parent captive, also known as a pure captive, is typically owned by one business. It is used to insure the business that owns it, as well as any affiliated entities. This structure is appropriate for some mid-sized businesses.
Group Captive
A group captive is typically owned by a group of businesses. These entities often share similar insurance needs. This structure is appropriate for many small and mid-sized businesses that share similar risk exposures.
Protected/Segregated Cell Captive
A protected or segregated cell structure allows a business to participate in a larger captive. This alternative is appropriate for some small and mid-sized businesses. Owners of the specialty segments or cells in a captive have the same rights as if they had purchased a separate captive. Each cell is funded separately and the assets are protected.
This structure offers many of the advantages of a single-parent or group captive, without requiring that an enterprise-level entity purchase and maintain a separate captive.
What Risks Can a Captive Insurance Company Cover?
Captive insurance financing covers a variety of different types of risks. Before purchasing coverage from a captive, however, a company must understand the unique exposures that it faces. A business cannot purchase coverage on a whim, for the sole purpose of reducing taxable income or creating a bank.
Coverage purchased from a captive must apply to actual insurance needs. Depending on the business and the structure of the captive, a wide variety of different insurance exposures may be covered.
Some of the exposures that may be purchased from a captive include the following:
- Property
- Liability
- Business interruption
- Cyber-liability
- Supply chain
- Employee or workers’ compensation
- Various other specialty exposures
These are only some of the various types of risks that may be covered by a captive. The options available depend on the business, the structure of the captive, and applicable laws and regulations.
Captive Insurance vs. Traditional Insurance
Traditional commercial insurance is a risk transfer product. The business that purchases the coverage is transferring risk to the commercial carrier in exchange for a premium. When an organization utilizes a captive to provide insurance, it is retaining more of the risk than it would with commercial insurance.
A comparative analysis of commercial insurance and captive insurance is provided in the table below.
| Traditional Insurance | Captive Insurance |
| Owned by outside third party | Typically owned by businesses |
| Coverage is more standardized | Coverage may be more customized |
| Premiums paid to outside carrier | Premiums paid to captive |
| No direct control over insurance program | Increased control and responsibility |
| No risk of loss except for premium | Captive may have retained risk |
Neither traditional insurance nor captive insurance is appropriate for every business. The selection of an appropriate risk financing structure depends on the business’s unique exposures and needs.
Is Captive Insurance Right for Your Business?
A captive insurance company should never be established for the sole purpose of generating income or reducing taxes. While a well-structured captive may produce income, it exists to manage risk, not to create profits.
A business may wish to utilize a captive insurance company if it meets the following criteria:
- The business has significant and ongoing insurance costs
- The business has strong financial and managerial capabilities
- The business has identifiable risk exposures that could be reduced
- The business has the capacity and desire to invest in risk financing
- The business is willing and able to comply with all applicable regulations
Many small and mid-sized businesses do not meet these requirements. Consequently, they do not benefit from utilizing a captive to finance and manage risk exposures. Those that do meet the criteria, however, should seriously consider the option.
Understanding the Costs of Forming a Captive
One of the most common misconceptions about captive insurance is that it is inexpensive and relatively simple. In truth, captive insurance typically involves significant expenses. In addition to the costs related to forming a captive, additional expenditures are incurred as the entity begins to operate.
Some of the expenses related to a captive insurance company include the following:
- Feasibility study
- Legal fees
- Licensing and legal entity formation costs
- Capitalization of the captive
- Actuarial services
- Accounting services
- Tax compliance and preparation
- Claims administration
- Captive management
- Annual reporting
The economic realities of establishing and operating a captive must be carefully considered. They are often more challenging than many small and mid-sized business owners expect. Conducting a thorough analysis of costs and benefits is an essential starting point.
The Importance of a Captive Insurance Feasibility Study
A captive insurance company is not appropriate for every business. Before making the commitment to form a captive, a company must carefully analyze its options. One of the best ways to evaluate the situation is to conduct a captive insurance feasibility study. This process considers the current environment, the company’s exposures, and the potential costs and benefits.
A feasibility study typically includes a detailed analysis of the following:
- Current insurance costs
- Claims history
- Business exposures
- Premiums that would be charged to the business if a captive were utilized
- Capitalization requirements of the captive
- Annual expenses associated with the captive
- Necessary expenditures related to reinsurance
There is no benefit to forcing a business into a captive insurance arrangement simply because the idea is appealing. Instead, the focus should be on determining whether it is the appropriate risk financing option.
Potential Tax Considerations
Tax considerations often play a role in the decision to utilize a captive insurance company. The situation is more complicated than many people realize. There are numerous variables that affect the outcome of a tax analysis related to captive insurance. As a result, every situation must be analyzed individually.
There may be situations in which a business utilizes a captive to finance insurance and also reduce taxable income. Tax planning is an appropriate activity when a business wishes to optimize its operations. It becomes a problem, however, when businesses begin believing that they have discovered a way to reduce their income by utilizing a captive. Anyone who promotes captive insurance as a means of reducing taxes misunderstands the process.
There are a number of warning signs, including the following:
- A claim is denied with no explanation
- The premiums are unrealistically high
- The business is encouraged to treat the captive as a bank account
- No documentation is provided
- Promises are made that are too good to be true
A tax professional, attorney, and insurance professional should review every situation.
Common Captive Insurance Mistakes to Avoid
There are several common mistakes that lead to issues with a captive. Some of the most common errors that can occur when establishing and operating a captive insurance company include the following:
Creating a Captive Insurance Company Without a Legitimate Purpose
A captive insurance company must have a purpose. It is possible for a company to purchase coverage from a commercial carrier without utilizing a captive structure.
Similarly, a company cannot purchase coverage from a captive simply because the arrangement is desirable. Owners of captives must invest in the entity and expect to earn a return on that investment, but the insurance company itself must serve a legitimate function.
Charging Unrealistic Premiums
Premiums must be set at an appropriate level. Some businesses mistakenly believe that they should charge unrealistically high amounts simply because they own a captive. This practice is entirely inappropriate.
Anyone that recommends purchasing insurance from a captive and charging an unrealistic amount misunderstands the entire process. Premiums should be set at a rate that reflects the value of the coverage.
Ignoring Claims
An insurance company should carefully review and analyze claims. A business that utilizes a captive insurance company should not ignore the process or assume that its needs will be handled without oversight.
Insurance coverage purchased from a captive works in the same way as coverage from a commercial carrier. As such, it is appropriate and necessary to review claims and ensure that they are legitimate and submitted correctly.
Poor Documentation
Proper documentation is essential when an entity buys insurance. Failure to maintain appropriate documentation results in a lack of visibility into the process. It also makes it more likely that problems will arise. Businesses that purchase coverage from a captive must retain copies of the underwriting, policies, premiums, claims, and more.
Treating a Captive Like a Bank Account
A captive insurance company is not a bank account. While there may be income and expenses, the entity’s assets are not available for unrestricted use. Anyone that utilizes a captive insurance company must understand the limitations and treat the entity as an insurance vehicle, rather than a bank account.
How to Get Started With Captive Insurance
Small and mid-sized business owners considering alternative risk financing options should carefully assess their situation.It is important to thoroughly understand the options available, as well as the risks and rewards of each.
Following this general guide is a good way to begin the process:
Step 1: Evaluate Current Insurance Needs
Review the current insurance situation and analyze the company’s major risks and exposures. This is an excellent opportunity to make adjustments to the insurance program. It may also be an appropriate time to reassess the business’s safety and risk management strategy.
Step 2: Determine Eligible Risks
Carefully review the company’s exposures and identify those that could be covered by a captive. Some exposures may not be appropriate for a captive structure.
Step 3: Complete a Captive Insurance Feasibility Study
Analyze the situation and consider whether a captive is the best way to finance and manage qualifying risk exposures.
Step 4: Select an Appropriate Captive Insurance Structure
There are many different structures available, depending on the business’s needs.
Captives typically fall into one of the following categories:
- Single-parent: This type of captive is owned by a single business.
- Group: This type of captive is typically owned by a group of businesses that share similar exposures.
- Protected/Segregated Cell: This type of captive allows an owner or group of owners to buy a segment or cell within a larger captive.
- Other options: There are several other types of captives.
Step 5: Focus on Governance and Compliance Issues
Once the structure has been decided upon, the next steps involve making sure that everything is properly documented and that the captive complies with all applicable laws and regulations. This is an extremely important step in the process.
Step 6: Always Revisit and Update
The situation for any given business can change over time. As conditions change, so should the risk management strategy. Make sure to revisit the captive program periodically and update it as needed.
Expert Insights
At Bespoke Insurance Groups, we believe that captive insurance makes economic sense for some small and mid-sized businesses. Captive insurance can provide enhanced opportunities to manage certain risks and reduce costs. The decision to utilize a captive structure, however, should not be made lightly. Any business that is considering the opportunity should carefully review its current insurance program and risk exposures. It should also understand the economic realities of utilizing a captive. A reputable captive insurance advisor can help the business determine if it is a good fit.
Statistics
Thousands of captives operate worldwide. Captive insurance has historically been utilized by large multinational organizations as a way to finance and manage certain risk exposures.
Small and mid-sized businesses should carefully consider the various options, including group captives, protected cell captives, and other alternatives. Insurance costs continue to rise, and many organizations are looking for ways to manage the increases.
Because every situation is different, it is always important to review the facts and figures related to a given industry before making a decision.
FAQs
What Is Captive Insurance in Simple Terms?
Captive insurance involves purchasing insurance from a captive company, rather than a commercial carrier. Most businesses do not have any ownership interest or control over commercial insurance companies—a captive insurance company is owned and controlled by the business that purchases coverage.
Can Small Businesses Use Captive Insurance?
Some small businesses may utilize captive insurance. However, it is not an appropriate risk financing option for every situation. Every business should carefully weigh the economic realities and analyze its risk exposures.
How Much Does It Cost to Form a Captive Insurance Company?
The cost of forming a captive varies considerably. There are many different types of captives, and each requires a separate review of costs and benefits. In addition, the costs and expenses related to forming and operating a captive insurance company must be reviewed.
Is Captive Insurance Only for Large Corporations?
No. While many captives have historically been utilized by large multinational corporations, there are many options for small and mid-sized businesses, including group captives.
What Types of Risks Can a Captive Cover?
The types of risks that a captive can cover vary considerably. It depends on the business and the structure of the captive.
Some of the exposures that may be purchased from a captive include the following:
- Property
- Liability
- Business interruption
- Cyber-liability
- Supply chain
- Employee or workers’ compensation
- Other specialty exposures
How Do I Know Whether Captive Insurance Is Right for My Company?
A detailed economic analysis can help determine whether a captive makes sense for a given business. Anyone considering the opportunity should take advantage of the guidance and support of a qualified captive insurance advisor.
Are There Tax Benefits to Captive Insurance?
Tax benefits are often a consideration when analyzing the potential benefits of a captive insurance company. The situation is more complicated than many people realize. Businesses should always work with qualified tax professionals, attorneys, and insurance advisors before making a decision.
Conclusion
Captive insurance provides an opportunity for small and mid-sized businesses to finance and manage qualifying risk exposures. The opportunity has advantages and drawbacks, and the process of purchasing coverage from a captive insurance company is complex.
A properly structured captive can provide enhanced control over some of a business’s largest costs, while improving its risk management strategy. It is an extremely important process, however, to make sure that a captive is appropriate for a given business’s needs and exposures. Those that understand the situation and analyze it carefully have the best opportunity for success. At Bespoke Insurance Groups, we can help you determine whether a captive is the best way to finance and manage risk exposures.
Contact Bespoke Insurance Groups
Are you a small or mid-sized business owner that is considering captive insurance? If your business has significant insurance costs and you wish to explore your options, Bespoke Insurance Groups can help. Our team of professionals can work with you to determine whether captive insurance makes economic sense for your business and help you make the most of the opportunity.
A captive insurance company is an enhanced way to finance and manage risk, but it is not appropriate for every situation. If your company has significant costs, exposures, and the ability to invest in alternative risk financing, it may be a good fit. Contact Bespoke Insurance Groups to determine whether it makes sense for your situation.